Solo 401(k) plans, also called Individual 401(k) plans, enable owners to tax-defer up to $57,000 in taxes for 2020 or $63,500 if you are at least 50 years of age and make catch up contributions. Contributing even a much lower amount can mean significant tax savings for this year. The great news, if you’re self-employed and want to save on taxes this year and/or start putting away a meaningful amount for retirement, there is still time, but don’t wait past year-end.
Purchase a Plan by 12/30 to Have Until Your Tax Deadline to Save on 2020 Taxes
Solo 401(k)s, which are for the self-employed or any multiple owner business that does not have any employees, must be setup by December 31, 2020 to receive tax benefits. It can take a day to turn your plan live, so make sure you complete by December 30th. The good news is that you’ll have until your tax filing deadline (April 15, 2021 for most business types) to make profit sharing contributions into your 401(k) and still receive the tax benefits for 2020.
Here's an Example of How to Lower Your 2020 Taxes by ~$8,000 or More
The amount you can tax defer will vary by your earnings and your effective tax rate. Here’s a hypothetical example of how an owner who makes an employer contribution of $36,000 will lower taxes by $8,280, assuming an effective tax rate of 23%, versus a person that doesn’t contribute:
Example Calculation and Comparison
|With a 401(k) Contribution||Without a 401(k) Contribution|
|20% of Net Self-Employment Contribution||$36,000||$0|
|Taxes Owed (23% Effective Tax Rate)||$33,120||$41,400|
The owner that contributed to a Solo 401(k) paid $8,280 less in taxes. In actuality, the tax savings could be even greater as the 401(k) contribution may also drop the owner a tax bracket and/or lower the effective tax rate more than the owner that did not contribute. And, you build for retirement too! Remember, this is an example and not meant as tax advice. Be sure to consult a tax advisor to discuss your specific situation and verify your tax deadline and potential savings.
The Inside Scoop on Solo 401(k) Contribution Rules
Since you’re both an employer and employee when it comes to your Solo 401(k) plan, to make the most of your plan, the smart moves are to set up a recurring monthly amount for regular saving of 5-10% of your earnings as an “employee.” Then, at the end of the year, determine your tax situation and make a one-time, “employer” contribution that best balances your tax saving needs with your retirement savings goals before the filing deadline.
If your business is structured as a corporation, you can make employer contributions up to 25% of net earnings into the 401(k) plan. If you’re a sole proprietor or own an LLC (or partnership), this percentage changes to 20% of your net schedule C. Just keep in mind that total contributions as an employer and employee cannot exceed a combined total of $57,000 for the 2020 tax year. A reminder that all employee contributions must be elected prior to the calendar year end, unlike your employer contributions for which you have until your tax deadline. Happy saving.